Climate Change and Its Economic Implications

In an August 5, 2021 posting, Diane Coyle makes the case for action on climate change. The UN Food Systems Summit in September and the UN climate conference (COP26) in Glasgow in November are obvious opportunities to move from incremental reform to significant progress…The challenge is really one of leadership: a small group of global political leaders could agree to address some of these wicked problems in the common interest of all...Analyzing the risks of catastrophe creates the obligation to act now. 

This posting seeks to address the relationship between potential climate change scenarios and the related effects on national economies such as that of the United States.  It then turns to potential responses that might ameliorate both the change in climate and related economic damages.  Finally, I will take a stab at whether such responses are likely to occur. If not now, when?

Clearly, a description of various climate change scenarios should serve as the place to start.

Martin Weitzman and Gernot Wagner (see Economic Letters article (2018) and Climate Shock (2015)) argue that economists and policy makers should explore what they characterize as “equilibrium climate sensitivity” (ECS) which highlights the estimated range and probabilities of possible increases in global temperature as the first step in determining the economic effects.  In a 2019 TED talk, Wagner highlights how the the Intergovernmental Panel on Climate Change (IPCC) estimates have evolved over time. 

The IPCC Report

We now have the August 7, 2021 physical science report of the IPCC . The following table and statements are taken from the Summary for Policy Makers of the IPCC report (AR6.)

SSP refers to shared socio-economic pathways.  The various SSP levels start with level 1 – which features global population peaking at 7 billion and then declining as well as significant reduction in activities that generate greenhouse gases (GHG.)  The higher SSP levels relate to larger populations and/or lower mitigation and adaption rates.  Here are a few pertinent claims made in the report.

  • Paragraph A.4.4 of the report states: The equilibrium climate sensitivity is an important quantity used to estimate how the climate responds to radiative forcing. Based on multiple lines of evidence, the very likely range of equilibrium climate sensitivity is between 2°C (high confidence) and 5°C (medium confidence). The AR6 assessed best estimate is 3°C with a likely range of 2.5°C to 4°C (high confidence), compared to 1.5°C to 4.5°C in AR5, which did not provide a best estimate.
  • Paragraph B.1.2 of the IPCC report concludes: Crossing the 2°C global warming level in the mid-term period (2041–2060) is very likely to occur under the very high GHG emissions scenario (SSP5-8.5), likely to occur under the high GHG emissions scenario (SSP3-7.0), and more likely than not to occur in the intermediate GHG emissions scenario (SSP2-4.5).
  • Section D of the report addresses Limiting Future Climate Change.  Paragraph D.1 states: From a physical science perspective, limiting human-induced global warming to a specific level requires limiting cumulative CO2 emissions, reaching at least net zero CO2 emissions, along with strong reductions in other greenhouse gas emissions. Strong, rapid and sustained reductions in CH4 emissions would also limit the warming effect resulting from declining aerosol pollution and would improve air quality.

Although the report cites 3°C as its best estimate, even the differences between a 1.5oC and 2oC increase are far from trivial. For example, previous IPCC reports indicated that: About 14% of the world’s population would be exposed to extreme heat waves once every five years if global temperature increases are held to 1.5oC; that percentage jumps to 37% with a rise of 2oC.

The August 2021 release limits itself to judgments regarding the physical science basis for climate change based on various population and policy-based mitigation and adaptation scenarios.  The report makes no attempt to estimate the economic effects of the scenarios it evaluates.  We now turn to discussion of those effects.

The Economic Effects of Climate Change

In July 2021, Michael Kiley, Deputy Director of the Division of Financial Stability of the (U.S.) Federal Reserve Board, reported on work that assesses the risks to economic activity from climate change. Rather than limit his analysis to average (mean) values, he breaks the distribution of potential outcomes into 10 equal parts (deciles) based on income per capita levels. He explores the implications for people in each income decile and in different parts of the globe. In the paper, he reports the regression analyses of temperature levels and other factors on real per capita income based on data from 124 countries over the period 1961-2010.  Here are a few of his conclusions.

  • The results show a very strong impact of temperature on Growth at Risk – downside risk to GDP growth, as measured by the lower quantiles of the growth distribution. For example, the impact of climate change on income for the lowest income groups is 50% larger than the effect on income groups at the median level.
  • There is a negative cross-sectional correlation between real GDP per capita and temperature- (and) hotter countries (also) tend to be poorer. For example, globally, a 1oC increase in temperature is estimated to yield a 1.9 percentage point decrease in income for those at the 10% (lowest income) percentile and a smaller 1.3 percentage point decline for those at the median income level.
  • The differences in income per capita declines across deciles in the United States (a high income country with a temperate climate) are relatively modest:  -0.75% at the 10th decile versus -0.60% at the median and -0.48% at the 90th percentile.  Based on World Bank data, the average growth rate of real GDP per capita since 2000 has been 0.94%; so, based on the median estimate, income per capita growth would decline by two-thirds.
  • In contrast, for Brazil (relatively warmer and with lower income than the U.S.), the GDP per capita decline at the 10th percentile is estimated to be -2.85% versus -1.97% at the median and -1.24% at the 90th percentile.  Since 2000, real income per capita in Brazil has grown (on average) by 1.01% per year; thus, estimated climate change would send growth rates well below zero. 
  • The results for India and Nigeria (two large, hot, low income countries) suggest even larger declines in GDP per capita.  Kiley’s estimates for the decline in median income are roughly 2.5% per year for each country.  With these climate related effects, growth in income per capita at the median in India would fall from roughly 4.5% to year to 2% per year.  For Nigeria, the decline would be from 2.6% to 0.1%.  In short, the average standard of living in Nigeria would stagnate at its relatively low level.
  • Kiley notes that he only considered how differences in temperature affected GDP per capita and did not consider other climatic effects such as increases in rainfall, drought, or wildfires.  Thus, he concludes that …the analysis of the links between temperature and the distribution of economic growth found herein are only one step toward understanding the effect of climate change on risks to economic growth. Clearly, climate change will yield very significant economic damage that will affect everyone but especially those with low incomes or who live in very warm climates.

In an August 2021 report, economist Jean Pisani-Ferry argues that, given the urgent need to address climate change characterized above, economic policy makers must plan for a challenging transition to carbon neutrality.  Here are a few key points from his Peterson Institute brief.

  • One way or another, decarbonization will put a price on a resource that used to be free, forcing an economic adjustment that will raise prices and trigger labor reallocation and other adjustments in carbon-intensive economic sectors, including autos, heavy industry, and transport.
  • Years of procrastination now imply a choice between an abrupt transition and catastrophic climate change. But the sudden pricing of carbon entails an adverse supply shock comparable in nature and size to the oil shocks of the 1970s.  The late 1970s in the U.S. featured economic stagflation; that is both high inflation rates and low economic growth with high unemployment.
  • The building of a carbon-free economy will bring a surge in investment to replace old carbon-based processes, while lowering consumption and putting pressure on public finances. A tradeoff looms between short-term sacrifice and future wellbeing. Macroeconomists must devise strategies that soften the blow of these challenges and make the best of the potential of decarbonization.
  • Too often the transition to a carbon-neutral economy has been pictured as a rather benign endeavor. … Transition costs, while bearable are likely to be significant…policy makers should face reality and design transition strategies accordingly. The transition to net zero will imply sizeable relative price changes, accelerated obsolescence of the existing capital stock, significant reallocation of labor, and a major investment push. All these changes need to take place just to achieve the relatively optimistic goal of carbon neutrality by 2050.
  • To be consistent with the goal of remaining within the carbon budget, that is to be consistent with limiting the rise in temperature to 2 degrees Celsius, the price of carbon will need to rise from $10 per ton (a rough global average with a range from $0 to $125) to at least $40 per ton presently and to at least $75 per ton by 2030.
  • Politically, a commitment to redistribute the proceeds from taxation dollar for dollar may be indispensable to dispel suspicions that carbon pricing is just a convenient pretext for increasing taxes.  Such a commitment must also address the burden of these price increases on low and middle income families, especially if their income from carbon production activities falls precipitously. Policies such as various proposed carbon fee and dividend programs as well as compensation for those in fossil fuel generating activities will need to be significant and thus costly.
  • The transition to net zero will confront policymakers with serious macroeconomic difficulties…A better, more precise discussion on the macroeconomics of climate action is urgently needed…debates should focus more on identifying the mechanisms and choices involved in what is bound to be a challenging transition. To convince politicians and the public to take serious action to decarbonize, these choices should be addressed thoroughly and clearly.

Policy Responses

Economist Matthew Kahn has written many papers and several books related to environmental economics in general and climate change in particular.  Some have targeted economists as the primary audience while others have sought to inform the public at large and policy-makers in particular.  His most recent book (2021) entitled Adapting to Climate Change: Markets and the Management of Uncertainty highlights various aspects of how climate change will affect people and the nature of the adaptations that many will make to sustain a desirable quality of life.  He notes that we have two principal strategies for addressing climate change: mitigating the effects – through means such as reducing use of fossil fuels to generate electricity, heating and cooling buildings, and transporting goods – and adapting how and where we live in response to the potential threats posed by more volatile temperatures, water flows, and fires.  Clearly, both are critical to keeping within the carbon budget objective.

Kahn argues that market signals can play key roles in real estate, labor, capital, food and insurance markets.  For example, building in flood plains would become more expensive either directly through the actions builders would need to take to protect against flooding or to the insurance premiums building owners would have to pay.  Of course, if public policy compensates owners for their losses, then they have less incentive to make these necessary adaptations.

Will households and businesses adapt to such increased risk?  Advocates for behavioral economics differ markedly from those who argue that faced with prices that reflect increased risk and scarcity, people will adapt their behavior.  For example, given climate change that features significant potential for rising temperatures and increasing drought conditions, believers in behavioral economics might argue that farmers will not change what plants they would grow; whereas, believers in traditional economics would assert that farmers would substitute crops that would be more robust in light of these potential forces as well as hedge their risks through futures market contracting. Kahn provides five examples contrasting these two views in his 2015 paper in Economists’ Voice. Consistent with Kahn’s observations, the August 21st issue of The Economist reports that the global investment in energy transition (…decarbonizing everything from energy and transportation to industry and farming) has grown from just over $200 billion in 2010 to more than $500 billion in 2020.

The IPCC report, which represents the work of natural scientists, does not take into account how people might adapt their economic behavior.  Of course, people won’t adapt sufficiently to counter all such risk, but their actions are essential to staying within the carbon budget, especially if they have incentives to do so.  In particular, if a significant broad-based carbon price or fee is introduced, say initially at $25 per ton and set to rise by $25 per year for the foreseeable future, traditional economics would suggest substantial adaptation would happen over the next few years.    What evidence do we have for such adaptation?

Carbon fees at a significant level have not been implemented in most countries. John Roome, Senior Director at the World Bank’s Climate Change Group, argues that carbon pricing is nowhere near where it should be [as it] still covers only a small part of global emissions at prices too low to significantly reduce emissions.   When they have been introduced as a serious response to GHG, the effects have been significant.  Consider what Sweden has done.  A recent Tax Foundation report  yields the following findings:

  • Sweden levies the highest carbon tax rate in the world, at SEK 1,190 (US $126) per metric ton of CO2. The tax is primarily levied on fossil fuels used for heating purposes and motor fuels.
  • Since the carbon tax was implemented 30 years ago, Sweden’s carbon emissions have been declining (see chart below), while there has been steady economic growth.  Sweden’s carbon tax revenues are significant but have been decreasing slightly over the last decade.
  • Some of this decline in both revenues and GHGs is the result of Swedish households and businesses adapting their behavior to be less dependent on fossil fuels, a desirable outcome.
  • Due to numerous exemptions, Sweden’s carbon tax covers only about 40 percent of all greenhouse gases emitted nationally…Levying a single carbon tax on all sectors would eliminate these distortions and potentially further reduce emissions.

Of course, implementing either a carbon fee or a carbon tax will generate substantial political opposition such as the vociferous French “yellow jacket” protests that began in 2018. In conjunction with the efforts of the Citizens Climate Lobby and the Climate Leadership Council, among others, I believe that when most of the fees collected from GHG sources are distributed to households on a per household basis, low and middle income households will be net beneficiaries; thus, some of the opposition to the program could diminish. See the U.S. Treasury chart below.

Public Policy

There are many reasons to be pessimistic regarding whether our global political and economic institutions will respond constructively to the “code red” signal provided by the IPCC scientists in their most recent report.

Matthew Kahn argues that we face a global “free rider” problem in which no specific institution (political or economic) has the incentive to reduce the GHG emissions for which it is responsible since global collective action is needed.  Thus, the continued dominance of fossil fuels in economic activity yields a tragedy of commons for the global community at large.  According to Joschka Fisher, former Germany foreign minister and vice chancellor, in an August 20, 2021 article entitled National Egoism vs. Planetary Responsibility And less we forget, the Paris targets are relatively minimal goals that would only slow the climate crisis, not end it decisively.  The countries that signed the agreement in December 2015 did so of their own volition and are free to set their national determined contributions as they see fit. 

He goes on to argue that: The central conundrum of the climate crisis is that we must rely on the structures of a global system based on the egoism of nation-states.  Joint action to fend off a common threat on behalf of all humanity must be taken through the narrower, older channels of sovereignty.  The idea of global responsibility to maintain the basis for our common survival is alien to such a system.  Coming to grips with this disconnect will be the great challenge of the twenty-first century…Unfortunately, the history of our species shows that genuinely inclusive global cooperation is not one of our strong suits.

The August 14, 2021 issue of The Economist states the challenge very clearly:

The budget associated with a 50% chance of keeping warming below 1.5o C – the more ambitious of the two goals laid out in the Paris agreement of 2015 – allows just 500 billion more tons to be emitted.  That is about 15 years of industrial admissions at current rates. To avoid busting that budget would require the whole world to get net emissions of carbon dioxide down to zero before 2050…Even the most ambitious of the various emissions scenarios modeled by the IPCC’s experts offers less than a 50% chance of staying below 1.5o C of heating.

The IMF has proposed a constructive start with a global minimum carbon fee of $75 per ton for rich countries, $50 per ton for middle income countries, and $25 per ton for poor countries.  If the large economies can get on board, our chances of staying within the carbon budget increase markedly.

The August 14th Economist article concludes as follows:

Deciding how much action to take on climate change is politically hard (a wicked problem to quote Diane Coyle) because it means imposing high costs today for largely hidden benefits tomorrow.  But when, in November (2021), the world’s governments get together in Glasgow to discuss how they can improve on the insufficient action they have taken to date, they need to think like people who have seen blood in the water.

Collective action in any individual country is difficult. Global attempts to get countries to act collectively to address such “wicked” problems as climate change is even more difficult. In a 2013 book entitled The End of Power, Moises Naim argues that in all arenas – political, economic, and religious among others – the likelihood of generating sustainable power to take the type of collective action needed to address climate change has been markedly reduced in recent years. A future blog will be devoted to reviewing Naim’s important book.

Teenagers such as Greta Thunberg have clearly explained who loses from the lack of serious policy responses.  If we don’t respond now, any future response will come with a much higher cost to both our health and our material well-being.

2 thoughts on “Climate Change and Its Economic Implications

  1. This is more an essay than a post ;), but I will give some responses:

    (1) GDP doesn’t measure many things and it’s also a flow. The loss of capital stock (“green infrastructure”) will make us poor, in terms of the lost “income” from the environment.

    (2) “Kiley notes that he only considered how differences in temperature affected GDP per capita and did not consider other climatic effects such as increases in rainfall, drought, or wildfires.” — since these OTHER elements reinforce each other, expect exponential damages.

    (3) The best time for carbon taxes was 25 years ago. The second best time is NOW. The ETS price is now €60/ton

    (4) Kahn is right about the collective action problem. I don’t see it getting resolved. Here’s my litmus test:


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